10/22/20141 Long-Run Aggregate Supply and Aggregate Demand Chapter 11

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Long-Run Aggregate Long-Run Aggregate Supply andSupply and

Aggregate DemandAggregate Demand

Chapter 11Chapter 11

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OutlineOutline

From Short Run to Long RunFrom Short Run to Long Run Long Run Equilibrium in the AD-AS Long Run Equilibrium in the AD-AS

ModelModel Economic Growth and On-Going Economic Growth and On-Going

InflationInflation The Inflation-Unemployment The Inflation-Unemployment

RelationshipRelationship Taxation and ASTaxation and AS

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From Short Run to Long RunFrom Short Run to Long RunLong Run (LR)Short Run (SR)

output prices,output prices are flexible,

wages, and other input pricesbut wages and other input prices

are all flexible.are inflexible.

A period in which

P P

Q($bil) Q($bil)

P3

AS1

ASLR

P1

P2

Qf

AS1

Qf

P2

P1

P3

a1

a1

The SRAS is upward-sloping. The LRAS is vertical at Qf.

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From Short Run to Long RunFrom Short Run to Long RunThree assumptions about SRAS AS1:

(1) The initial price level is P1; (2) this price level is expected to persist;

(3) the price level can be flexible both upward and downward

P P

Q($bil) Q($bil)

P3

AS1

ASLR

P1

P2

Q3 Qf Q2

AS1

AS3

AS2

Qf

P2

P1

P3

a1

a2

a3

a1

a3

a2b1

At a1, the economy operates at full employment, potential output Qf. The price level is P1. The unemployment rate is un,

the natural rate of unemployment.

Now suppose that the price level rises to P2. In the SR, nominal wages and input prices remain unchanged.

Firms incur the same costs. Higher output prices increase their revenuesand thus their profits.

Firms increase output to Q2. The economy moves up to point a2 on AS1, which slopes upward.The nation’s unemployment rate declines below its natural rate.

Vice versa. if the price level falls from P1 to P3. In the SR, firms make lessprofits because lower prices decrease their revenues while they incur

the same input costs. Firms decrease output to Q3.

The economy moves down to point a3 on AS1.

The nation’s unemployment rate rises above its natural rate.

In the LR, output prices, wages and input prices are all flexible. If the price level rises from P1 to P2, firms increase output in the SR.

The economy moves up along AS1.Wages and input prices also increase, shifting AS1 to the left to AS2.

The economy moves to point b1 on LRAS and AS2.

The nation’s unemployment rate rises to its natural rate.The LRAS is vertical at Qf.

c1

In the LR, output prices, wages and input prices are all flexible. If the price level falls from P1 to P3, firms decrease output in the SR.

The economy moves down along AS1.Wages and input prices also decrease, shifting AS1 to the right to AS3.

The economy moves to point c1 on LRAS and AS3.

The nation’s unemployment rate falls to its natural rate.Again, the LRAS is vertical at Qf.

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LR Equilibrium in the AD-AS LR Equilibrium in the AD-AS ModelModel

Demand-pull inflation in the LR AD-Demand-pull inflation in the LR AD-AS modelAS model

Cost-push inflation in the LR AD-AS Cost-push inflation in the LR AD-AS modelmodel

Recession in the LR AD-AS modelRecession in the LR AD-AS model

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The LR AD-AS model is a model in The LR AD-AS model is a model in which the equilibrium price level and which the equilibrium price level and the level of real GDP are determined the level of real GDP are determined by the intersection of the AD curve by the intersection of the AD curve and the LRAS curve.and the LRAS curve.

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Price LevelP (index)

Real GDP($billion)

LRAS AS1

AD1

P1

Qf

LR equilibrium occurs where three curves, LRAS, SRAS, and AD, intersect.The economy achieves its LR equilibrium at E1 and

produces full-employment output Qf.

E1

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Demand-pull inflation in LR AD-AS Demand-pull inflation in LR AD-AS modelmodel


Real GDP($billion)

LRAS AS1

AD1

P1

Qf

In the SR, an increase in AD from AD1 to AD2 causes demand-pull inflation. The price level and real GDP both rise.

The economy moves from E1 to E2.

E1 AD2

P2E2

Q2

In the LR, wages and input prices also rise, causing the SRAS curve to shift leftward, from AS1 to AS2. Real GDP falls back to its prior level Qf,

and the price level rises to P3. The economy moves from E2 to E3.

AS2

E3P3

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Cost-push inflation in LR AD-AS modelCost-push inflation in LR AD-AS model


Real GDP($billion)

LRAS AS1

AD1

P1

Qf

In the SR, a decrease in AS from AS1 to AS2 causes cost-push inflation. The price level rises and real GDP falls.


E1 AD2

P2 E2

Q2

If the government does nothing, in the LR, the reduction in real GDP lowers thedemand for inputs. Wages and input prices fall, causing AS to shift back to AS2.

The economy moves from E1 to E2 then eventually back to E1.

AS2

E3P3

However, if the government counters the decline in real GDP by increasing ADfrom AD1 to AD2, the price level will rise to P3.The economy moves from E1 to E2 then to E3.

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Recession in LR AD-AS modelRecession in LR AD-AS model


Real GDP($billion)

LRAS AS2

AD2

P3

Qf

In the SR, a decrease in AD from AD1 to AD2 causes a recession. Both the price level and real GDP fall.


E3 AD1

P2 E2

Q2

If the government does nothing, in the LR, the reduction in real GDP lowers thedemand for inputs. Wages and input prices fall, causing AS to shift to AS2.

The economy moves from E1 to E2 then eventually to E3.

AS1

E1P1

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SummarySummary

Situation Cause Outcomes

Demand-pullinflation

Cost-pushinflation

Recession

AD up

AS down

AD down

Q up (U down)P up

Q down (U up)P up

Q down (U up)P down

Outcomes (Laissez-faire non-intervention policy)

AS down

AS up

AS up

Q down (U up)P up (more inflation)

Q up (U down)P down

Q up (U down)P down (more deflation)

Short Run Long Run

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SummarySummary

Situation Cause Outcomes

Demand-pullinflation

Cost-pushinflation

Recession

AD up

AS down

AD down

Q up (U down)P up

Q down (U up)P up

Q down (U up)P down

OutcomesGovernment intervention

AD down

AD up

AD up

Q down (U up)P down

Q up (U down)P up (more inflation)

Q up (U down)P up

Short Run Long Run

AD downQ down (U up/higher)

P down

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Production possibilities and Production possibilities and LRASLRAS

Consumer goods Real GDP

Capital goods Price level

Originally, the economy’s PPC is AB. The LR aggregate supply is LRAS1, the full-employment real GDP is Q1.

A

B

C

D

LRAS1 LRAS2

Q1 Q2

In the LR, supply factors (advances in technology and more and better resources) cause the economy to grow. The PPC shifts to the right to CD.

The economy’s LRAS also shifts to the right to LRAS2, where Q2 is the new real GDP.

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Economic Growth and On-Going Economic Growth and On-Going InflationInflation

Price levelP

Real GDPQ

Originally, the economy achieved LR equilibrium at E1, where LRAS1, AS1, and AD1 cross.The price level is P1 and the full-employment real GDP Q1.

AD1

AS1

LRAS1

Q1

E1P1

Over time, supply factors shift both LRAS and AS to the right. Simultaneously, increases in population and money supply also shifts AD to the right.

The economy grows but experiences higher prices or on-going inflation.

AD2

AS2

E2P2

Q2

LRAS2

Over long periods, any inflation that occurs is the result of the growth of AD.

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The Inflation-Unemployment The Inflation-Unemployment RelationshipRelationship

SR trade-off: the Phillips curveSR trade-off: the Phillips curveAS shocks and shifts of the Phillips AS shocks and shifts of the Phillips

curvecurveNo LR inflation-unemployment trade-No LR inflation-unemployment trade-

offoff

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Three important pointsThree important points

Under normal circumstances, a SR trade-Under normal circumstances, a SR trade-off exists between the rate of inflation, off exists between the rate of inflation, p (%), and the rate of unemployment, p (%), and the rate of unemployment, u (%).u (%).

AS shocks can cause both higher rates of AS shocks can cause both higher rates of inflation and higher rates of inflation and higher rates of unemployment.unemployment.

No significant trade-off exists between No significant trade-off exists between inflation and unemployment over long inflation and unemployment over long periods of time.periods of time.

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SR trade-off: the Phillips curve SR trade-off: the Phillips curve (PC)(PC)

Q u (%)

P p (%)

Originally, the economy achieves equilibrium at a. The price level is P1 and real GDP Q1,as shown on the left diagram below.

At a, the corresponding inflation rate is p1 and unemployment rate u1,as shown on the right diagram.

PC1

u2 u1

AD1

Q1

aP1

AS1

ap1

In the SR, an increase in AD shifts the AD curve to the right to AD2, causing the pricelevel to rise to P2, i.e. higher inflation, and real GDP to rise to Q2, i.e. lower

unemployment. The economy moves from a to b on both diagrams.

AD2

bP2

bp2

In the SR, a decrease in AD shifts the AD curve to the left to AD3, causing the pricelevel to fall to P3, i.e. lower inflation, and real GDP to fall to Q3, i.e. higher

unemployment. The economy moves from a to c on both diagrams.

AD3

Q2

c

P3p3

c

Q3u3

The SR Phillips curve PC1 is drawn by connecting three points a, b, and c.It shows a trade-off between the inflation rate, p(%), and the unemployment rate, u(%).

When one rate is higher, the other rate is lower, and vice versa.The SR Phillips curve is derived as a result of shifts in AD.

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AS shocks and shifts of the Phillips AS shocks and shifts of the Phillips curvecurve

Q u (%)

P p (%)

Originally, the economy achieves equilibrium at a. The price level is P1 and real GDP Q1,as shown on the left diagram below.

At a, the corresponding inflation rate is p1 and unemployment rate u1,as shown on the right diagram. Point a is on PC1.

PC1

u2 u1

AD1

Q1

aP1

AS1

ap1

In the SR, an increase in AS shifts the AS curve to the right to AS2, causing the pricelevel to fall to P2, i.e. lower inflation, and real GDP to rise to Q2, i.e. lower

unemployment. The economy moves from a to b on both diagrams.

bP2

b

p2

In the SR, a decrease in AS shifts the AS curve to the left to AS3, causing the pricelevel to rise to P3, i.e. higher inflation, and real GDP to fall to Q3, i.e. higher

unemployment. The economy moves from a to c on both diagrams.

Q2

c

P3p3

c

Q3u3

Since three points a, b, and c, cannot be on the same SR Phillips curve, it meansthat the Phillips curve shifts.

Shifts/changes in AS cause both inflation and unemployment rates to change inthe opposite direction.

The SR Phillips curve shifts in opposite directions with a shift in SRAS.

AS3

AS2 PC3PC2

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No LR inflation-unemployment No LR inflation-unemployment trade-offtrade-off

Q u(%)

P p(%)

Originally, the economy is at a on both diagrams. The LR aggregate supply is LRAS, the AD is AD1 and the SR PC is PC1.The economy achieves full-employment real GDP Qf,

at the natural rate of unemployment un.

P2

a

LRPCLRAS

Qf un

AD1

a

PC1

AD3

P3

c c

P1

PC3

PC2

AD2

bb

a’

b’

In the LR, AD increases to AD2, causing the economy to move from point a to a’ onthe right diagram. LR self-adjustment brings the economy to point b on both diagrams,

back to Qf and un again. The process continues.

The LR Phillips curve is vertical at the natural rate of unemployment, un,which corresponds to the full-employment, potential output Qf,

from where the LRAS starts.

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Taxation and ASTaxation and AS

The Laffer curveThe Laffer curveCriticisms, rebuttal, and Criticisms, rebuttal, and

assessmentassessment

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Supply-side economicsSupply-side economics

A view of macroeconomics that A view of macroeconomics that emphasizes the role of marginal tax emphasizes the role of marginal tax rates and other factors that affect rates and other factors that affect LRAS and therefore affect inflation, LRAS and therefore affect inflation, unemployment, and economic growth.unemployment, and economic growth.

Marginal tax rates, the rates on extra Marginal tax rates, the rates on extra dollars of income, vary from 10% to dollars of income, vary from 10% to 35% in the U.S.35% in the U.S.

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Taxation and ASTaxation and AS

High marginal tax rates reduce High marginal tax rates reduce people’s incentives to work, save, or people’s incentives to work, save, or invest more.invest more.

To expand LRAS and economic To expand LRAS and economic growth, government should lower growth, government should lower marginal tax rates.marginal tax rates.

Changing marginal tax rates affect Changing marginal tax rates affect government tax revenue.government tax revenue.

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The Laffer curveThe Laffer curve

Tax rate(%)

Tax revenue ($)

m

Maximum taxrevenue

Low tax rates increase productivity, output,and thus tax revenue

High tax rates reduce productivity, output,and thus tax revenue

Marginal tax rates negatively affect productivity, output, and tax revenue.

Laffer curve

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Criticisms, rebuttals, and Criticisms, rebuttals, and assessmentassessment

Skeptics say there is ample empirical Skeptics say there is ample empirical evidence showing that the impact of evidence showing that the impact of a tax cut on incentives is small, of a tax cut on incentives is small, of uncertain direction, and relatively uncertain direction, and relatively slow to emerge.slow to emerge.

The issue of where a particular The issue of where a particular economy is located on its Laffer economy is located on its Laffer curve is an empirical question.curve is an empirical question.

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Supply-side advocates contend that Supply-side advocates contend that the Reagan tax cuts in the 1980s the Reagan tax cuts in the 1980s worked as Laffer predicted.worked as Laffer predicted.

The tax-rate cuts did not, however, The tax-rate cuts did not, however, produce extraordinary rightward produce extraordinary rightward shifts of the LRAS..shifts of the LRAS..

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There is general agreement that the There is general agreement that the U.S. economy is operating at a point U.S. economy is operating at a point below m on the Laffer curve.below m on the Laffer curve.

Supply-side economics has Supply-side economics has contributed to how economists and contributed to how economists and policymakers design and implement policymakers design and implement fiscal policy.fiscal policy.

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10/22/20141 Long-Run Aggregate Supply and Aggregate Demand Chapter 11